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Paving the Way for German Unification

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1990
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Market-oriented reform in the German Democratic Republic: The big bang of 1990

On October 3, 1990, the German Democratic Republic (GDR) ceased to exist. It is survived by five federal states, which on the same day joined the Federal Republic of Germany (FRG). The demise of the political and economic system of the GDR and the rebirth of the region within the boundaries of an enlarged FRG poses daunting issues that will have to be resolved with determination and prudence. This article makes a first and brief attempt at a politico-economic postmortem of the GDR and chronicles the economic resurrection of its offsprings.

Background

Until 1989, official GDR statistics painted a rosy picture of the economy. According to these statistics, in 1980-88, real produced net national income (broadly equivalent to net national product excluding part of the services sector) increased at an average annual rate of 4 percent; net investment grew by 2 percent; real per capita income rose by 4.5 percent; prices were stable; the external accounts were mostly in surplus; unemployment did not exist; and government accounts were in balance. In retrospect, it seems fair to conclude that these numbers were largely fictitious.

The economy seems to have done much worse for several reasons. First, the system of central planning led to a high degree of inflexibility of the economy. Adjustment to the external shocks of the 1970s and 1980s, as well as the emergence of new technologies and changes in the demands of increasingly sophisticated consumers, became very difficult. Second, the pursuit of economic autarky and the lack of integration into a competitive world economy resulted in inefficiencies and a loss in economic welfare. Concentration of investment in a few technology-intensive areas selected for political reasons led to a deterioration of the capital stock in many other areas, most notably in the consumer durables industry and infrastructure as well as harmful environmental effects. Finally, the all-pervasive regulation of the labor market, the rigid wage structure with little wage differentiation between different skill levels, and the rising gap in living standards between the GDR and the FRG contributed to declining morale and performance of the workforce. Embedded in the political developments elsewhere in Eastern Europe and the Soviet Union, the mounting economic problems, combined with the inability of the authorities to deal with them, prepared the basis for the revolution of 1989/90.

Initially, there was the view that the GDR could on its own undertake a radical economic and currency reform like that of 1948 (see “Radical Currency Reform: Germany 1948” by Thomas Mayer and Gunther Thumann, Finance & Development, March 1990), stabilize the economy in the aftermath, and generate enough economic growth to allow rapid convergence with FRG living standards. Unification with the Federal Republic would then come as the crowning achievement of the reform process. This view was reflected in FRG Chancellor Helmut Kohl’s ten point plan for unification published in November 1989. But it soon became clear that time was running out for the reformers in the East. Increasing emigration to the FRG was threatening to bring the GDR economy to a standstill, while the new political leadership of the country was not able to implement fundamental economic reforms. In addition, the external political environment seemed to favor a quick push for German unification. Against this background, on February 6, 1990, Chancellor Kohl, in a surprise move, proposed that economic, monetary, and social union take place by mid-1990.

A more comprehensive analysis of German economic unification is scheduled for publication in the IMF’s “Occasional Paper Series.”

The plan

Changing a command economy into a market economic system was a daunting task, and one for which no blueprint existed. In principle, it entailed a comprehensive reform of the institutions and a fundamental change in the rules of the economic game; the state, which in a command economy typically comprises the government, along with most of the business sector and the banking system, had to be dismembered. Private ownership of the means of production, decentralized decisionmaking, competition, market-determined pricing, and freedom of movement of labor, capital, goods, and services had to be introduced.

In other circumstances, the transformation of these principles to actual reform could have taken a considerable period of time. But the GDR, which shared the same historical and cultural background as the FRG, could take a short cut by wholesale adoption of most of the legal framework of the latter. This approach was taken in the “Treaty Between the Federal Republic of Germany and the German Democratic Republic Establishing a Monetary, Economic and Social Union,” or, in short, the GEMSU (German Economic, Monetary, and Social Union) Treaty. It was drafted within weeks after Chancellor Kohl had proposed monetary and economic union, signed by the two governments in May 1990, and put into effect on July 1, 1990. The GEMSU Treaty provided a concrete framework with all the essential ingredients of a modern “social market economy”: sound money, an efficient economic order based on private ownership, fiscal discipline and federal fiscal structures, a social safety net, and protection of the environment. The subsequent Trust Fund Law and the Unification Treaty reinforced the foundations laid by the GEMSU Treaty. The main features of the latter are summarized in the following.

Monetary union. The deutsche mark became the sole legal tender in the GDR, and the Deutsche Bundesbank took charge of monetary policy in the enlarged deutsche mark currency area. A point of much contention had been the rate used for converting monetary stocks and financial flows. As in the 1948 reform, the rate for the conversion of stocks could have been chosen such as to eliminate the relatively moderate excess liquidity in the private household sector. However, this consideration was soon overshadowed by the concern that too low a rate would not give sufficient relief to the highly indebted state enterprise sector.

In the end, financial assets and liabilities were in general converted into deutsche marks at a rate of M 2: DM 1. Residents of the GDR, however, could exchange a substantial part of their savings at parity. In the consolidated balance sheet of the banking system, the conversion resulted in a conversion rate for financial assets of private households of M 1.5: DM 1 and an average conversion rate for all financial stocks of about M 1.8 to DM 1. The rules of conversion implied that the assets of the banking system were on average converted at a less favorable rate than the liabilities. The resulting gap was to be made up by equalization claims on the government that were issued by a special public fund and allocated to the banking system.

The conversion of flows—wages in particular—was guided by the objective to align wage differentials with productivity differentials to the FRG. The GEMSU Treaty stipulated conversion at par. At first glance, this seemed justified, given that average gross wages in industry amounted to about one third of the Federal Republic’s earnings and labor productivity was estimated at 30 to 40 percent of that in the FRG. This comparison, however, suffered from several shortcomings. First, there were severe statistical problems with the measurement of labor productivity in the GDR. Second, and more important, the calculations were backward-looking. It was impossible to produce a reliable projection of future labor productivity and wage developments on which a decision on the conversion rate could have been based. Third, it was questionable whether the specific conversion rate for flows would have a permanent influence on the price of labor in a common currency area with competition and labor mobility. Certainly, prices of tradeable goods would not be permanently affected by the choice of a specific conversion rate. Similarly, labor mobility limited the use of the conversion rate to achieve a certain wage differential to the FRG. Thus, the decision for quick monetary union implied that the exchange rate between the two currencies could not be used to influence competitiveness of the GDR for any extended length of time.

Economic union and privatization. The Treaty established the legal basis for an economic order in the GDR that was largely identical to that existing in the FRG. Above all, it introduced private ownership, competition, market-determined pricing, and the freedom of movement of labor, capital goods, and services. The GDR’s foreign trade was subjected to the principles of free world trade in line with the rules of the GATT and—over time—with the law and the policy goals of the EC. For agriculture and the food industry, the GDR had to introduce a price and external support scheme in line with the EC market regime. Remaining discrepancies in the economic order were subsequently removed in the Unification Treaty with transitional arrangements in specific cases.

The GEMSU Treaty established the principle of private ownership as one of the central pillars of the economy. To make this principle work, the vast state-owned enterprise sector had to be restructured and privatized. In June, legislation passed by the GDR parliament established the Trust Fund Institution (“Treuhandanstalt” or THA) as owner of the roughly 8,000 state-owned enterprises, with the mandate to restructure and privatize the viable ones and to liquidate the others. The rules for privatization and closures were flexible, leaving room for employment, social, and other political considerations in addition to profit maximization. The THA was given authority to borrow on the capital markets—up to DM 27 billion in 1990-91—to finance the restructuring of enterprises at a time when proceeds from privatization were still insufficient. It was also permitted to guarantee working capital loans to the enterprises.

Social union. The GEMSU Treaty transformed the monolithic social security system of the GDR into a structured system in line with that of the FRG. An unemployment insurance fund was created and the health, pension, and accident insurance funds were separated from the central government budget and constituted as separate entities with their own budgets. Rules governing contribution rates and benefit entitlements were taken over from the Federal Republic’s social security system. The health insurance fund was set up to cover medical expenses (hospital care, doctors’ fees, and medication) and certain sickness-related transfer payments.

Protection of the environment. In view of the huge overhang of environmental damage and the predominance of environmentally unsound production techniques, the GEMSU treaty included the establishment of a German environmental union as an objective in its own right. Accordingly, new plant and equipment investment in the (former) GDR is only authorized if it satisfies the safety and environmental requirements applicable in the FRG, and existing structures have to be adjusted so as to bring them up to FRG standards within the next five years.

Fiscal reform. Formerly, the state budget had been a cornerstone of central planning and therefore substantial alterations had to be made to adapt it to a market economic system. Major activities of the state, including the state-owned enterprises, the railways, and the postal services were removed from the budget. A federal fiscal system was established. Subsidies were abolished for consumer goods and subsidy cuts were scheduled for transportation, energy, and housing. A large cut in personnel expenditure was foreseen and all other expenditures were subjected to review. On the revenue side, the GEMSU Treaty required the adoption of a system of taxes, contributions, and fees practically identical to that of the FRG. Indirect taxes were introduced at the time of conversion, but a simplified system of income and corporation taxes was put into effect in the second half of 1990, with the full FRG system of direct taxes to be in place from January 1991.

Implementing the changes

While the currency conversion proceeded smoothly, problems soon began to arise in several other areas. The abrupt exposure of the manufacturing sector to competition from abroad led to a sharp drop in sales and output, while workers succeeded in obtaining large wage increases. Unemployment soared and a liquidity crisis ensued for most enterprises. Since banks were not able to bear the risks associated with lending to the enterprise sector, the Trust Fund had to extend guarantees in substantive amounts to prevent an economic collapse. The much larger than expected deterioration of the economic situation increased the fiscal costs of unification such that a third supplementary federal budget of more than DM 26 billion became necessary for 1990 and the fiscal outlook for 1991 worsened. At the same time, the government-guaranteed borrowing by GDR enterprises created the risk of a larger-than-warranted domestic credit expansion in the currency area.

The centralized organizational set-up of the THA complicated operations. After the first three months of GEMSU, neither the closure of non-viable enterprises nor the restructuring or sale of viable enterprises had sufficiently advanced. More seriously, perhaps, the greater than expected problems of the enterprises and the assumption by the THA of contingent liabilities (guarantees for liquidity credits) further reduced its estimated net worth.

In addition, there was considerable uncertainty about property rights which inhibited the privatization of state assets and reduced the inflow of foreign investment. The state treaty establishing GEMSU did not include more than a passing reference to this important issue and a later declaration by the two governments ruled that priority be given to returning nationalized property to foreign owners; this deterred potential buyers who feared the later claims on their newly acquired assets.

The problems that ensued after GEMSU took effect, and other political and administrative difficulties, triggered a further acceleration of the unification process. In August, the two governments agreed to advance unification of the two German states from early 1991 to October 3, 1990. Among other things, political unification was supposed to allow a more efficient management of the rescue operation for the GDR economy. The treaty establishing political unity would also facilitate asset sales by shifting the risk of property disputes to the government. All sales of state assets to the private sector were made final and later claims by previous owners could be compensated financially by the government.

Outlook

Despite these difficulties, most observers believe that after the process of “creative destruction” is completed, the economy of the former GDR will take off and per capita GNP will converge to the Federal Republic’s levels within maybe a decade. Such a transformation of the economy implies an enormous increase in the demand for capital in East Germany, which will put upward pressure on real interest rates and the external value of the deutsche mark (part of which may already have been reflected in the markets). The external surplus of Germany as a whole will decline and net exports of foreign countries to Germany increase. Thus, German unification could, at least for a while, be a stimulus to growth in Europe and in the rest of the world. This scenario appears likely to materialize from today’s perspective provided the appropriate policy decisions are made.

First, there is an urgent need to accelerate the process of restructuring and sale of state-owned enterprises. The longer the government’s involvement in the management of the business sector, the greater is the risk that political rather than economic considerations would guide business decisions. The consequence would be higher costs of the restructuring and lower efficiency and growth.

Second, government borrowing for the financing of unification must be contained. While initial official estimates showed only a moderate rise in prospective budget deficits, more recent projections point to a potentially marked deterioration in the government finances, owing to a significant extent to measures aimed at sustaining consumption and employment in the GDR. If unchecked, a burgeoning deficit would almost certainly enforce a tightening of monetary policy and lead to higher interest rates, lower growth, and higher debt-service costs. To prevent such unfavorable developments, priority should be given to rigorous expenditure cuts. If these cuts prove insufficient to contain the deficit, then revenue measures may have to be considered as a last resort.

Third, economic union of the two Germanys reinforces the need for structural reforms in the FRG. Rigidities and disincentives affecting the labor market, agriculture, mining, shipbuilding, and other sectors supported by government subsidies and trade restrictions have tended at times to undermine economic efficiency in the FRG. Structural reforms, including “qualitative consolidation” of the public finances, could significantly shorten and facilitate the process of economic integration.

Clearly, the “big bang” approach to market-oriented reform taken in East Germany cannot be emulated in detail by other countries. Indeed, immediate trade liberalization, coupled with the hard currency policy, has even strained the financial resources of the FRG. Nevertheless, much of the general experience gathered in the GDR is likely to be valuable to even those countries that opt for a different approach to reform.

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